Inventory is a necessity for companies that sell physical products. Without inventory there will be no sales. Maintaining inventory does create risks.
These risks range from, storage, to proper quantity, to proper turnover. However, the most significant risk of all is cash. Inventory is a conversion of cash to a less liquid asset.
Simplistically, the more inventory on hand the less cash currently available. Reducing inventory risk and managing inventory levels is critical to manufacturing and retail industries.
In this post we will define inventory risk, cover the common risks encountered by companies, how to calculate inventory levels, and how to calculate the cash effects of maintaining inventory.
Inventory risk is the possibility that a company will not be able to sell inventory, or the value will decrease while in storage. Having too much inventory pulls from cash reserves and increases the probability of loss from damage or obsolescence. Having too little inventory runs the chance of missing out on sales.
Inventory is made up of three primary areas:
Most inventory risks can be broken down into four main categories. They are:
Overstocked – The overstocked risk is the company will have too much inventory on hand. When there is excess inventory the company has limited or restricted their ability to pursue other opportunities. In additional to the cost of producing the inventory, the company is incurring costs for storage, security, and insurance. Inventory represents cash the company cannot utilize. With less cash they are restricted on possible avenues for expansion, bonuses, etc.
Understocked – The opposite of overstocked. This occurs when there is an understocked amount of inventory the company runs the risk of missing out on sales. If the company cannot fill orders due to lack of inventory, the customers will more than likely contact competitors. Lost sales have a significant impact on the overall health of a company.
Obsolescence – The obsolescence risk tends to go hand in hand with overstocked. Holding inventory too long can cause decrease in value or obsolescence. When this happens the company has to unload the inventory at a price below cost. This loss has a direct effect on the bottom line.
Damage – When storing inventory there is the risk it will be damaged and unsaleable. While the damage tends to happen to a small quantity of the inventory, there is still a loss that directly impacts the company.
The key to managing inventory risk is controlling what can be controlled. Overstocked and understocked are the main areas that management can control to reduce inventory risk. Obsolesce can happen anytime.
Damage can be controlled to a point, but it also can happen at any point.
To control overstocked and understocked inventory, management needs to incorporate the concept of the reorder point.
The formula for the reorder point is:
Add the lead time to the safety stock to determine the reorder point.
Assume Company A has average daily sales of 5 units. The best daily sales they have had is 10 units. When ordering raw materials, the average lead time is 25 days and the maximum lead time is 37 days. The calculated reorder point would be as follows:
While the reorder point is based on days in inventory, it does allow management to control the inventory levels based on sales. The safety stock prevents management from having too little and the lead time prevents management from over ordering. These factors allow management to reduce inventory risk to acceptable levels.
When inventory becomes obsolete, the write-off directly impacts the bottom line. These are cost that the company will never be able to recoup. To put an element of control in place, the company should consider inventory reduction sales. These sales accomplish two main goals:
Management should keep an eye on trends in the marketplace. If the trend indicates a shift from a current product, then reducing the sales price will help mitigate the obsolescence.
In cases were a product is updated every year, such as automobiles, then management should have plans in place to reduce the sales price at a predetermined time. Management will want to have enough time to fully reduce the inventory before the next sales cycle comes around.
For example, if the next model of a product comes out in January every year, then management should consider price reduction by the start of the fourth quarter. Each industry will have its own timing for reduction sales, but the key is to move the inventory before write-offs happen.
It is better to get a reduced sales price versus having to write off cost to the income statement.
When a company purchases inventory, they are effectively converting their cash into inventory. The inventory represents cash resources that can no longer be utilized for other opportunities.
The CFO must understand the cash aspects of inventory to properly forecast and strategically move the company forward.
A simple formula that will help comes from determining lines of credit. When management is seeking a line of credit, they need to calculate how much they need. Requesting a $100,000 line of credit from a bank, when the company needs $200,000, is not ideal. Therefore, there is a calculation that allows for an educated estimate on the amount of credit needed. This same calculation works well in determining cash held up in inventory.
The formula for a LOC is:
Utilizing this formula, management can see what their estimated cash need will be with the inventory days on hand. When the inventory days on hand increases, the formula will adjust out on the total cash needs.
While this formula is geared towards determining the LOC needed, it also shows management how much cash is being tied up in inventory. The efforts to reduce inventory risk should also include an understanding on the cash flow.
There will always be a risk associated with having inventory on hand. To mitigate this risk: